Root Cause of the Recession: Bad Consumer Credit

Includes: DIA, KBE, QQQ, SPY, XLF
by: James Wood

A simple explanation of the cause of the current economic problem: For 25 years, we have had enormous increases in consumer credit, much of which was neither necessary nor could the consumer pay back. When these consumer loans started going massively unpaid, the crisis erupted and it has led us to deflation of prices, which has led to recession and probably will end in depression.

A more professional explanation of the cause for the economic problem: Economists, particularly at the Fed, focus on the “private credit aggregates”, which includes all household and non-financial company debt used to finance consumption and investment (mortgages, auto loans, home equity loans, credit cards, etc). Then economists compare this to the nominal GDP (gross domestic product).

For 30 years, from 1954 to 1984, there was an extremely close relationship between private credit aggregates and GDP. (Go to the underlying article by Richard Clarida to see the chart demonstrating this.) In 1984, $3.5 trillion of nominal GDP was supported by $3.5 trillion of private credit outstanding.

By 2007, $14 trillion of nominal GDP was supported by $25 trillion of private credit outstanding. By 2007, we had nearly double the amount of private credit as a % of our GDP. We believe much of this excess to be unproductive debt which simply could not be paid back. This is the problem.

This unproductive credit is the reason for the crash of 2007 which continues today and will continue for at least some time more. The break with the traditional relationship of private credit with GDP is the indicator that we were getting too much bad consumer credit.

Today we know that bad credit as liar loans for home mortgages, adjustable rate mortgage loans where after a couple of years the rates went to levels that simply were not payable by the borrowers. As the increase in house value exploded upward, consumers took out home equity loans to spend on vacations. Virtually everyone assumed the increase in real estate was a permanent increase in wealth and therefore one could spend more and borrow more because the consumer was rich enough to afford it. Consumers took the attitude the credit card debt could be thought of as sort of permanent financing which did not really need to be paid off.

Then smart guys on Wall Street invented ways to make it easy to grant credit (mortgage backed securities guaranteed by companies who did not have the ability to honor their guarantee (AIG and bond rating agencies) and erroneously rated the debt as triple A credit.

This creative Wall Street financing made it possible for inherently bad loans to get financed. This is the imprudent and unproductive consumer debt that has led to the current crisis.

The next question is, logically, if we had the economic indicator, why are we talking it about it only now? Why didn’t someone sound the alarm? The simple reason is that the economists took their eye off the ball. The economists simply did not take seriously the private credit indicator.

But there were several specific reasons for not following the indicator. First, private credit and monetary aggregates have lot in common as indicators. But monetary aggregates were going through a transformation. monetary aggregates, which include checking, time and savings deposits in banks, used to be a pretty good measure of the amount of money in the economy.

But this was before we got securitizations which are bank type loans but outside the bank system. In the early 1980s, the only securitized loans were some mortgage backed securities. The shadow banking market which we have today did not exist. As a result, monetary aggregates and private credit were nearly the same in the 1980’s but they very vastly different by 2007.

Furthermore, economists were in practice basically only tracking inflation and the increase in the GDP. Since other indicators seemed to be better predictors of inflation and GDP, economists seemed to have stopped looking at private credit. This was a serious mistake.

Summarizing, 25 years ago private credit started growing much faster than GDP. This led to an immense amount of bad credit that had to explode at some point. The housing market started exploding in 2005 and the financial markets in 2007. We are now in the process of normalizing our credit with all the adverse attendant consequences. When the consumer credit market stops working, it ultimately takes with it manufacturing, finance and other dependent sectors.

Two economic realities fall out of the decline of consumer credit. They have serious ongoing consequences for the economy.

  1. Deflation is here and has much further to go. While many thought deflation was not possible, it is not only possible but it is currently a primary factor in understanding much of what is happening in the economy. For a free, outstanding description of “deflation”, get Bob Prechter’s description of deflation here. Relevant points: Deflation is always initiated by credit excesses, which we clearly have now. Webster defines deflation as a contraction in the volume of money and credit relative to available goods. That is to say, price declines are a consequence of less money and credit for the same amount of goods. This has important consequences in coming months for the value of all asset classes, including housing, commercial real estate, gold, oil other commodities as well as stocks and bonds. They will all being going down as result of a reduction in available private credit. While inflation, even hyperinflation (because of the government stimulus program) may be a problem down the road, for the coming months, maybe even a year or two, holding long any of the asset classes mentioned above is likely to cause a reduction in your net worth. This writer believes we are currently in a bear market rally and we will soon see the ongoing deflation effect lead to much further declines in the price of all asset classes. This view has technical support in that there are clear signs the private credit will continue the make important reductions in the quantity of credit in spite of the government economic stimulus plan.
  2. The government economic stimulus will largely fail. While the government is putting various trillions of dollars into economic stimulus, the reduction of private credit is in the tens of trillions and this makes economic stimulus look puny in terms of the market generated loss of private credit. There is not enough government money to recover the loss of private credit. This writer, perhaps erroneously, believes he has a unique insight which he calls the “Wood Limitation to Economic Stimulus”. This rule says that government economic stimulus will work at the beginning of the economic cycle and in the middle where additional credit will be found for productive investment uses. But at the peak of the business cycle, most useful applications of credit have been found and additional money goes to unproductive uses, condemning them to failure. A New York Times article perfectly illustrates the problem. The article says if we use the new mortgage lending guidelines, we are not going to have much lending. The implicit suggestion is that we ease up on the lending guidelines, but the problem is that we will just generate more bad credit with lax credit standards. The “Wood Limitation” explains why former Fed Chairman Alan Greenspan talked about conundrums (referring long term bond rates not following short rate increases) and Paul Krugman in his recent book “The Return of Depression Economics” says wistfully that economic stimulus “sometimes works and sometimes does not work”. At this point in time, much of the stimulus money of the government will inevitably go to non productive purposes because we are at the end of an historic business cycle.

This writer believes the undue expansion of consumer credit, and the resulting unproductive credit that cannot be paid, is the simple explanation for the economic problems we have today. We were happy to see the prices go up, particularly our housing, because we felt rich.

But we are shocked when the bad credit explodes and the economy starts to right it itself to the new reality, including job loss and the decline of our asset values which makes us much poorer. More prudent government management of the economy could have avoided both excesses, i.e. the artificial high from excessive credit and the terrible collapse from the resulting bad credit.

We need widespread agreement that greatly increased bad consumer debt is a root cause of our current problems, and that bad credit leads to the deflationary effect on prices. If we can agree on that, we would probably hold better public discussions on the best actions for government to take to deal with the problem.

This article relies heavily on information taken from an outstanding article written by Richard Clarida of Pimco. I recommend you read his more professional telling of the facts.